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21 May 2018

How Should Investors Navigate the New Environment of U.S. Stock Market?

In 2017, all news seemed to be good news and U.S. stocks moved consistently higher, while volatility stayed remarkably low. Now well into 2018 and it’s a completely different world—most news is seen through more negative lenses, volatility has returned and although stock indexes have rebounded off their lows, they continue to struggle a bit to find direction.

There’s no yellow-brick road to follow, so how should investors deal with this new world? In a word—patience. We don’t believe we’re on the precipice of a prolonged downturn in stocks, but an uptrend may be difficult to sustain in the coming months. We’re entering a traditionally weak seasonal time of the year and midterm election years have not been kind to the bulls in the past. Even though past performance does not guarantee future results, the S&P 500’s average loss (or “maximum drawdown”) during midterm years has been 17%, largely concentrated in the first three quarters; with subsequent one-year rallies of an average 32% from our analysis. Before trying to time that “trade,” however, remember that successful market timing requires two correct decisions—you have to get both the sell and the buy decisions right. History often rhymes but rarely repeats exactly, and given more rapid movements related to algorithmic trading, that timing could be compressed, thrown off, or entirely different this time.

Conditions improved, but more work may need to be done

Earning season has bested elevated expectations, with the S&P 500 posting earnings growth to-date of 26%, above the roughly 16% expected coming into the season, according to Thomson Reuters. Some companies have been rewarded, but the indexes struggled in the first month of the quarter, before rebounding more sharply in May. Courtesy of a stock market that hasn’t yet taken out its January highs, and the surge in forward earnings expectations, valuations have improved. The S&P 500’s forward P/E dropped from 18.6 in late January, to 16.5 currently—only slightly above the 20-year average according to Thomson Reuters.

Investor sentiment also corrected along with the market’s correction, with the Ned Davis Research (NDR) Crowd Sentiment Poll now in neutral territory. It’s the extreme pessimism zone which has historically been associated with the most robust stock gains, in keeping with the contrarian nature of sentiment. In addition, consumer confidence has remained elevated and in a zone which NDR has shown to be associated with the weakest returns in stocks.

Bear not in sight

While a sustained upward move has some formidable constraints, a prolonged bear market seems unlikely given the limited risk of an economic recession in the near-to-medium terms. Economic data has been modestly softer recently, but that’s helped to lower the expectations bar, which could set up the opportunity for the surprise factor to improve. Remember, when it comes to the connection between economic fundamentals and stock market performance, “better or worse (relative to expectations) tends to matter more than good or bad.”

Additionally, both Institute of Supply Management (ISM) surveys—manufacturing and services—remain comfortably in expansion territory (above 50), despite easing a bit recently; while the forward-looking new orders component for both indexes remain above 60.

The labor market also looks healthy, with the forward-looking jobless claims number remaining near historic lows, 164,000 jobs added in April, and an unemployment rate which fell to 3.9%--the lowest level since 2000. However, wage gains remain modest, with average hourly earnings (AHE) rising 2.6% year-over-year, in line with last month’s downwardly-revised level.

In the midst of this relatively good earnings and economic news, there are continuing trade and geopolitical concerns weighing on the market and sentiment. Trade rhetoric has been harsh at times from both sides, but negotiations are ongoing and to date, no substantial trade actions have yet been taken, which is good news. At this point, we view the risks as asymmetric—with investor sentiment suggesting a worse-case scenario is expected, meaning market’s would likely take kindly to a more benign or positive outcome.

Monetary tightening and fiscal stimulus

The Federal Reserve maintained the current level of short-term interest rates at its most recent meeting but gave no indication that it will deviate from its path of gradual hikes—noting that inflation will “run near” the bank’s 2% target. Fed officials have also expressed a willingness to tolerate inflation moving above that level for some time (a “symmetric” view about inflation) to cement the reflationary theme. The latest inflation data shows still-subdued upside pressure, but leading indicators for inflation—including tax cuts, the closure of the “output gap,” and a tighter labor market—have firmed. Of all the concerns weighing on the market, inflation and monetary policy are the ones we view as most important—a more aggressive Federal Reserve could quickly change the outlook for both the timing of the next recession and the longevity of the bull market in stocks.

So what?

A more challenging investing environment requires a more disciplined and patient investing approach. The next few months could continue to be choppy, but a U.S. recession still appears a ways off, which should keep the bull market intact.

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Consumer Confidence Index is a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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